Market demand and supply

Key concepts introduced so far:

1. Economics studies the "best use of scarce

resources", that is, the organization of the economic
system that produces the allocation of resources
that best meets social objectives
2. Scarce resources imply the existence of the
production possibilities frontier (limits to
production), productive efficiency and opportunity
costs in meeting the societal objectives.
3. Economic systems answer three fundamental
questions: what, how and for whom to produce.
4. Different economic systems answer these three
questions differently: market economy, command
economy, mixed economy.
 General definitions
Market
Mechanism through which buyers and sellers come
into contact and interact in order to exchange goods
or services, setting the price and quantity to be
exchanged
Demand
quantity of a good that consumers want to buy at
each price level
Supply
quantity of a good that producers wish to sell for
each price level
Equilibrium price
price for which the quantity offered is equal to the
quantity demanded
 Market economy
In a market economy, private actors are responsible for solving the
three economic problems:
what: consumers, "dollar votes" in their daily purchase decisions.
how: competition between firms
for whom: remuneration of production factors (profits, wages,
rents)
In summary: the coordination of individuals, activities and
companies takes place automatically, through a price system.
Everything has a price, which is the value of the good in terms of
money.
Prices act as signals for producers and consumers, coordinating
their decisions: higher prices tend to reduce consumer purchases
and encourage production and vice versa. This brings prices to the
equilibrium level.
The market mechanism: supply and demand
 The functioning of the market system is described by A.
Smith through the metaphor of the "Invisible Hand"

Idea of the invisible hand: there is no central authority that

establishes what should be the optimal allocation of social
resources but the actions of private actors, guided by their
personal interest as by an invisible hand, spontaneously
produce an optimal social result in terms of efficiency.
The self-interest of competing producers in making the highest profit from the
sale of their product and that of consumers in buying the higher-quality
products at the lowest prices pushes producers to continuous improvements in
production to better meet consumer preferences (in this way market supply and
demand tend to meet).

The "Invisible Hand" is the mechanism that allows the balance of the
markets: supply and demand on different markets tend to be equal trough
price adjustments, eliminating any excess of demand or supply
Example: gasoline prices, supply and demand
In the United States, gasoline prices have undergone extreme variations over the
past fifty years. Supply cuts in the 1970s caused two serious "oil shocks" that led
to riots and the call for more regulation. Decreases in demand due to new
energy-saving technologies led to a prolonged drop in prices after 1980. When
the oil cartel reduced supply in late 1999, crude oil prices increased again. The
concepts of supply and demand are essential to understand these trends.
Prices, supply and demand

According to the theory of supply and demand, consumer

preferences determine the demand for consumption of goods
(Demand curve), while the costs faced by enterprises are
the basis of the supply of goods (Supply curve)
Building the demand curve (D)
The demand curve has a
Price negative slope (Law of
P
downward-sloping
demand) and relates the
quantity demanded to
P
the price
1

0 Quantity
Q Q
1

As the price increases, the quantity demanded decreases because alternative goods
are purchased (substitution effect) and because the consumer has to make a
greater economic sacrifice for the purchase reducing the real income (income effect)
The demand curve
Demand curve refers to the sum of
the quantities demanded by all
individuals of that market at each
price level
The demand curve
Shows the relationship between P and Q demanded, all other
factors being equal
 “Other factors” includes:
– The average income of consumers: when
income rises, people buy more (even if
price don't change)
Price

– Price of related goods (substitute goods

like white or brown sugar or
complementary goods, like cars and
gasoline)
– Size of the market (population): when
population increases the quantity increases
– Tastes or preferences of consumers:
variation in cultural or psychological
D inclinations to buy a good.
– Special influences (e.g. the typical weather
of a city influences the demand for
Quantity umbrellas or air conditioners)
 variations in these "other conditions" affect the
position of the demand curve
Two ways in which demand can
increase/decrease

 (1) A movement
along the demand
curve from A to B
 it is solely due to a
P0 A consumers reaction to a
P1 change in the price of
B that good
D

Q0 Q1 Quantity
 (2) A shift of the
demand curve from
D0 to D1 causes an
increase in the
quantity demanded,
P0 C for each price level.
A
For example, for P0
the quantity
D1
D0 demanded increases
Q0 Q1 Quantity from Q0 to Q1
Increased demand for cars could be due to:

increase in the average

income, increase in
population, reduction in
gasoline prices
Construction of the supply curve
Price
P

The supply curve has a

P positive slope (upward-
1
sloping supply) and relates
the quantity supplied to
the price

0 Quantity
Q
1 Q
The supply curve has a positive slope because the higher the price at which a good is sold on
the market (compared to production costs), the greater are the chances of making profits for
companies, which will therefore increase their productive investment in that market, instead of
devoting their production to other goods or services. If the price is low to the point of not
covering production costs, production is zero (no firm has an interest in producing at a loss).
We refer to the market supply: the sum of the quantities offered by all companies at each price
level
Supply curve (S)

It relates the quantity supplied and the price

The supply curve(S)
Shows the relationship between P and Q supplied, all other
factors being equal  “Other factors” includes:
–The cost of production: when production
costs for a good are low relative to the
market price, it is profitable for producers
Price

S to supply a great deal.

– Technological advances: this advances
enable to produce more goods at the
same cost making profitable increasing the
quantity supplied.
–Prices of related goods: if the price of
one production substitute rises, the supply
of another substitute will decrease
–Government policies: e.g., product safety
regulations that are more stringent
increase production costs.
–Special influences (e.g. the weather
Quantity exerts an important influence on farming
and on the ski industry)
 variations in these "other conditions" affect
the position of the supply curve
Increase in the supply of cars
(e.g. decrease in costs)
 IN SUMMARY

Demand: reveals consumers' preference to buy a certain

good for each price level; the position is influenced by the
conditions that affect preferences (tastes, income,
population, price of related goods).

Supply: reveals the incentive of companies to produce a

certain good for each price level (based on the possibility of
profit given the production costs); the position is influenced
by the conditions that affect production costs and profit
possibilities (technology, profit possibilities by investing in
alternative goods, cost of production factors, public
regulation that affects costs).
Equilibrium of supply and demand

• Market equilibrium is
S obtained at point E0,
Price

D
the point at which the
quantity demanded
P0 equals the quantity
E0
supplied: for a price
P0 and a quantity Q0
S D
Q0 Quantity
Equilibrium of supply and demand
Equilibrium of supply and demand

Market
equilibrium is
given by the
intersection point
of the supply and
demand curves
A shift of the demand curve

E.g.: if the price of a

substitute good goes up
.f.o.r each price level the
D1 S quantity demanded will
Price

D0
increase.
P1 E1 The demand curve will
P0 E0
shift from D0 to D1.
The market will reach a
new equilibrium at the
S D0 D1 point E1.
Q0 Q1 Quantity
A shift of the supply curve

Product safety regulations

S1 that are more stringent
S0 increase production costs.
Price

D
The supply curve shifts up
E1 to S1
P1 If the price were still P0,
P0 E0 there would be an excess
of demand
Therefore the market
S0 D moves towards a new
Q1 Q0 Quantity equilibrium in E1.
Shifts in supply and demand
Immigration into a region could shift the supply curve for labor to the right and
pushes down wages (a) but workers tend to move to those cities where the
demand for labor is already rising because of a strong local economy: where
a shift in labor supply is associated with a higher demand curve, the new
equilibrium wage is the same as the original wage.
The elasticity of demand (see Chapter 4)

The reactivity of consumers to changes in the P of the

good determines the elasticity of demand.
The more consumers are sensitive / react to variations in
P, the greater the elasticity.

∆Q/Q
∆P/P
If el. > 1, then the demand is very elastic (high
sensitivity). Eg. Luxury goods
If el. <1, then the demand is not very elastic (very low
reaction). Eg. Necessary consumer goods
The market:

• decides what to produce (there may be goods for

which no consumer is willing to pay the price
requested by the producers)
• decides how much of each good must be
produced… finding, for each market, the price for
which the quantity demanded equals that supply
• decides for whom to produce (for those
consumers who can and wish to pay the
equilibrium price)